Consider the following balance sheet (in millions) for an FI: Assets Liabilities Duration = 10 years $950 Duration = 2 years $860 Equity $90 What is the FI's duration gap? What is the FI's interest rate risk exposure? How can the FI use futures and forward contracts to put on a macrohedge?
DO not Answer Question 1-6, Only below question A-C needed.
21. Consider the following
Assets Liabilities
Duration = 10 years $950
Duration = 2 years $860
Equity $90
- What is the FI's duration gap?
- What is the FI's interest rate risk exposure?
- How can the FI use futures and forward contracts to put on a macrohedge?
- What is the impact on the FI's equity value if the relative change in interest rates is an increase of 1 percent? That is, DR/(1+R) = 0.01.
- Suppose that the FI in part (c) macrohedges using Treasury bond futures that are currently priced at 96. What is the impact on the FI's futures position if the relative change in all interest rates is an increase of 1 percent? That is, DR/(1+R) = 0.01. Assume that the deliverable Treasury bond has a duration of nine years.
- If the FI wants to macrohedge, how many Treasury bond futures contracts does it need?
In problem 21, we assumed that basis risk did not exist. That allowed us to assert that the percentage change in interest rates (DR/(1+R)) would be the same for both the futures and the underlying cash positions. If there is basis risk, then (DR/(1+R)) is not necessarily equal to (DRf/(1+Rf)). If the FI wants to fully hedge its interest rate risk exposure in an environment with basis risk, the required number of futures contracts must reflect the disparity in volatilities between the futures and cash markets.
A: Refer again to problem 21. How does consideration of basis risk change your answers to problem 21?
B: Compute the number of futures contracts required to construct a macrohedge if [DRf/(1+Rf) / DR/(1+R)] = br = 0.90 Explain what is meant by br = 0.90.
C . If br = 0.90, what information does this provide on the number of futures contracts needed to construct a macrohedge?
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